Monday, April 13, 2009

What is the role of animal spirits in the political sphere in producing economic crises?

“Conventional economic theories exclude the changing thought patterns and modes of doing business that bring on a crisis. They even exclude the loss of trust and confidence. They exclude the sense of fairness that inhibits the wage and price flexibility that could possibly stabilize an economy. They exclude the role of corruption and the sale of bad products in booms, and the role of their revelation when the bubbles burst. They also exclude the role of stories that interpret the economy. All of these exclusions from conventional explanations of how the economy behaves were responsible for the suspension of disbelief that led up to the current crisis” (George Akerlof and Robert Shiller, “Animal Spirits”, 2009, p 167).

I don’t have many problems with the argument of Akerlof and Shiller (A & S) that animal spirits play an important role in economic crises. I think they attempt to carry their argument too far; it seems to me that the economic system tends to be self-equilibrating despite notions of fairness and money illusion. But I accept that when there is high leverage in the system (i.e. high levels of debt relative to equity) it is a lot more vulnerable to economic crises than when there is low leverage. I also accept that changes in confidence help explain why leverage fluctuates. Stories that interpret the economy seem to have a big role in determining confidence. A few years ago it was common to hear the story that the risks involved in lending on housing were minimal – even “as safe as houses”. Now the story we hear is that investment in government-backed securities offers “a safe harbour”.

The main problem I have with this book is its failure to recognize that animal spirits also play a role in politics. In fact, as Arnold Kling and Clive Crook have pointed out, A & S fail to mention public choice theory. Instead, their model of government is what Kling describes as the “shockingly naive metaphor of a parent”. In their preface, A & S write:

“The proper role of the government, like the proper role of the advice-book parent, is to...give full rein to the creativity of capitalism. But it should also countervail the excesses that occur because of our animal spirits.”

Crook writes: “This is an unappealing analogy. I would sooner take up arms against a government that saw me as a child than vote for it.”

It seems to me that the most important animal spirit that Akerlof and Shiller fail to mention is the anti-market bias, stemming from an excessive desire for security and stability, which comes to the surface whenever a financial crisis threatens to occur. Rather than allowing the normal process of liquidation to occur when large financial institutions fail, the animal spirits that rule the political domain say that everything must be done to “keep the first domino from falling” (as A & S advocate on page 85).

When viewed in isolation, the bail-out of each institution seems like cheap insurance to government policy advisors. The problem is that a series of bail-outs tends to generate excessive confidence in central banks and governments. If you are lending money to a company that you expect to be backed by government, then you are not going to be too worried if the salary packages of the executives of that company give them incentives to take excessive risks. Creditors might not be surprised if the company gets into financial difficulty, but they will be shocked if it isn’t rescued by government.

From the A & S perspective the current crisis occurred not because parents encouraged the kids to act unwisely by incurring gambling debts , but because the parents decided to let one of their wayward children file for bankruptcy. That unsettled the creditors, so the parents lost their nerve and decided to pay all the kids’ debts. At this stage the lesson that the parents seem to have learned from this is that the kids need more parental supervision to make sure that their animal spirits don’t ever get out of control again. How will the kids respond? Will they leave home to get away from this parental supervision? Or will their animal spirits lead them to pretend to be good for a while in order to re-establish cosy relationships with their parents?

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